Understanding Impermanent Loss

Understanding Impermanent Loss in AMM Pools

Impermanent loss refers to the potential difference in value for holding tokens in an Automated Market Maker (AMM) compared to simply keeping them in a wallet. It occurs when the prices of tokens in a pool diverge from their value at the time of deposit. Should the prices revert to their initial levels, the loss reverses and is hence deemed 'impermanent'. However, if the discrepancy in prices persists, the loss solidifies as 'permanent'.

Though such losses can be offset by trading fees earned from Yield farming, a deep understanding of impermanent loss dynamics is strongly recommended.

For an in-depth understanding of impermanent loss, click here.

How to avoid Impermanent Loss?

  • Impermanent loss arises when there's a notable price disparity between assets in a liquidity pool. Considering the assets' historical price movements and volatility is crucial before providing liquidity. For assets known for high volatility or frequent price changes, opting for a broader price range may help mitigate the risk of impermanent loss. (Applies to V3 only).

  • Use correlation analysis to determine the relationship between the assets you're providing liquidity for:

- If the assets are highly correlated, it may reduce the risk of impermanent loss.

- If the assets have a low correlation, it may increase the risk of impermanent loss.

  • Both the size of the liquidity pool and trading volume can affect the risk of impermanent loss. Larger liquidity pools and higher trading volumes can generally reduce the risk of impermanent loss. You can use the analytics page to view historical trading volumes and liquidity pool size to determine the best liquidity strategies that suit your risk profile.

  • Because impermanent loss is an ongoing risk, users should monitor liquidity pools regularly and adjust their strategy as necessary. This may involve rebalancing your liquidity, re-adjusting your price ranges, or withdrawing liquidity altogether.

Understanding Impermanent Loss in V3

  • Due to the concentrated liquidity model allowing LPs to provide liquidity at specified price ranges, users may be exposed to more risk from price fluctuations compared to the traditional V2 model.

  • If the price of assets moves outside of the price range where liquidity is concentrated, LPs may face increased losses.

  • An impermanent loss occurs if the deposited assets change in price since the initial deposit.

  • If prices return to their previous levels, no impermanent loss occurs.

  • If funds are removed from the liquidity pool before the price returns to its original level, the status of the impermanent loss becomes permanent.

Example A: Narrow Range

  • Cassandra provides liquidity for a token pair (ETH and USDC) with a range of $1000-$1500. Cassandra will earn fees as long as the price stays within the $1000-$1500 range. If the price of the assets moves outside the selected price ranges, Cassandra may face significant losses.

Example B: Wide Range

  • Theseus provides liquidity for the same token pair, except with a wider price range of $500-$2500. Because Theseus' price range is wider he earns fees from a wider price movement, however, due to his wide range, Theseus' LP works less efficiently. If the price range maintains a range within $500-$2500, Theseus will have a smaller chance of experiencing impermanent loss compared to Cassandra's narrower range strategy.

Example C: Out of Range (Manual Mode)

  • Hylas provides liquidity for the token pair with a range of $800-$1200 (ETH-USDC). If the price goes up to $1200, Hylas will end up with only USDC. If the price later drops to $1000, Hylas would incur an impermanent loss because he had less exposure to ETH when the price was within his selected range.

impermanent loss when providing liquidity to V3 depends on the price range users select and how an asset's price changes. You can reduce the chance of impermanent loss by selecting a wider range, however, you may also earn less from trading fees.

Example D: (Auto Mode - Gamma)

Does the single-sided liquidity provision in V3 eliminate the risk of impermanent loss?

While single-sided liquidity can help reduce the impact of impermanent loss, there is always a risk associated with providing liquidity, especially regarding price volatility and market fluctuations.

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